Demystifying the VC term sheet: Protective Provisions

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

For the past several weeks, I’ve been exploring some of the more confusing terminology of VC term sheets. In my last post, I discussed who should control the Board following a Series A financing. Today, we’ll examine so-called “protective provisions,” which is a related control issue – and something investors always require.

Protective provisions grant the investors the right to veto or block certain corporate actions. Accordingly, even if the Board of Directors authorizes a particular action, the consent of a certain percentage of the preferred stockholders would be required prior to the company taking such action. The rationale for these provisions is to protect the investors (who are usually the minority stockholder following a Series A financing) from the majority stockholders.

Standard protective provisions: The following protective provisions are viewed as pretty standard and non-controversial (and are actually the provisions agreed-to in FourSquare’s Series B financing led by Andreessen Horowitz):

A sale of the company or other “Liquidation Event”

Any amendment to the company’s Certificate of Incorporation or Bylaws so as to alter or change the powers, preferences or special rights of the shares of Preferred Stock so as to affect them adversely

Any increase or decrease (other than by conversion) in the total number of authorized shares of Preferred Stock or Common Stock

The authorization or issuance of any equity security having a preference over, or being on a parity with, any series of Preferred Stock with respect to dividends, liquidation or redemption

The redemption or purchase of shares of Preferred Stock or Common Stock (subject to certain exceptions)

Any declaration or payment of any dividends or any other distribution on account of any shares of Preferred Stock or Common Stock

Any change in the authorized number of directors of the company.

Non-standard/Controversial protective provisions: Beyond the usual provisions, some investors will push for additional items, such as the following:

Any hiring, firing or change in the compensation of any executive officers

The entering into any transaction with any director, executive or employee of the Company

Any incurrence of indebtedness in excess of $[100,000]

Any change in the principal business of the company or the entering into any new line of business

Any purchase of a material amount of assets of another entity.

Founders should push back on these – and should be able to knock most (if not all) of them out if they have strong negotiating leverage.

Other Key Issues: There are two other issues you should focus on. First, founders should require a minimum threshold of outstanding shares of Preferred Stock in order for the protective provisions to remain in place. Thus, language should be inserted into the term sheet providing that the protective provisions would only be applicable “so long as [25]% of the originally issued Series A Preferred remains outstanding.”

Also, watch-out for high voting thresholds, particularly upon a Series B or later financing round. Founders are often able to negotiate a single vote for all investors (i.e., the Series B or later investors would not have a separate vote for their respective protective provisions). However, the requisite consent percentage should generally not be higher than 66 2/3 percent to avoid the scenario where an investor holding a small percentage of shares effectively has veto rights.

(Missed previous installments in this ongoing series? Click to learn more about the following issues:)

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.